CandleFocus

Underinvestment Problem

The underinvestment problem arises when a company relies heavily on debt financing, instead of the more conventional form of equity financing. As the company’s debt load grows, the company's ability to make investments in growth opportunities and future projects becomes strained. This leads to a lack of reinvestment in the company, which can stunt growth and eventual profitability.

The root of the issue lies in the fact that equity and debt holders have contrasting incentives. Equity shareholders expect the firm to be managed for growth, so its value can appreciate - which can be achieved through reinvestment and expansion. Debt holders, on the other hand, expect prompt payments from the firm, so they prioritize repayment of debt. This creates tension between both sides and leads to the underinvestment problem.

In some cases, the underinvestment problem can be greater than its original cause. For example, when a company is overleveraged and has difficulty paying off its debt, it has few options to save itself. One of those options may be a debt restructuring, which involves swapping debt for equity. However, debt exchanges sometimes do not provide sufficient funds to pay off some or all of the debt. This creates an additional burden of debt overhang to the firm, wherein the debt overhang acts as a detriment against investment into the company. This burden of debt overhang creates a more pronounced underinvestment problem, as it deters further investments from not only the firm’s equity holders, but also from any potential investors looking to buy into the firm.

The underinvestment problem can thus have a negative effect on shareholders and the economic growth of a nation that the company is located in. It is thus of paramount importance that companies look to control their debt burden, to ensure that they are not overleveraged, which may ultimately lead to the dreaded underinvestment problem. Governments of certain nations may also attempt to assist their companies in the event of debt overhang, by providing the necessary capital that may help alleviate the burden of debt overhang. This can be a cost to the government, but one that may pay off in the long-term by improving the economic health of its companies and citizens.

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